How Greece Will Drag Down Europe And Refuse To Leave

There's been a lot of talk lately about how likely it is that Greece will soon be forced to quit the Euro. If only the Greek crisis could end so simply.

A Greek exit from the euro would be an awful mess, but it would at least bring closure and a chance to move on. Greece would arguably have a better chance of recovering sooner. But best of all for the rest of us, Greece would no longer be a potential trigger for wider European or global crisis.

Well, no such luck. Greece will not leave the euro, and it's almost impossible to kick Greece out.

Instead of preparing for Greek exit, prepare instead for more of the same as Greek and other European leaders exchange threats, miss deadlines, suspend payments, spook markets, and seem to never get any closer to resolving anything.

That outlook stands regardless of who wins Greece's re-run elections on June 17. The first, failed ballot on May 6 made clear that Greek voters want their next government to be more defiant towards Europe. The new, radical parties that stole the limelight propose to break austerity promises made to Europe, default on debts to Europe unless it agrees to lend more leniently, and refuse to leave the euro no matter how badly the rest of Europe wants them to go.

Even if moderates make a comeback, they will be eager to prove that they too can defy European austerity demands and stand up to any pressure to quit the euro.

Many economists believe Greece would be better off if it could devalue its currency in order to quickly regain international competitiveness. But to be beneficial, devaluation would need to be a one-off followed by conservative stability. Greeks doubt it would work that way. Drachma inflation ran at an average annual rate of 20% from 1973 to 1994.

So Greece will cling to the euro, even at the price of a deeper depression. Only in the long run - I think in more than a year - will the Greek crisis finally approach some kind of end game.

But the most pressing issue by then will not be Greece's euro membership. Europe will eventually have to decide whether to provide Greece with a third, bigger bailout, or let the Greek banking system and economy collapse utterly.

How Greece Can Keep Muddling Along

Markets are accustomed to worrying about whether Greece will default on its public debts. But the real crux of the Greek crisis is its banking system, which has a hoard of assets ostensibly worth more than two years of Greek GDP, but actually worth a lot less.

Instead of trying to identify the losses, write them off and start fresh, the losses are being hidden and left to fester. The money that banks bring in from their maturing loans is being used to repay fleeing depositors. The supply of credit to the economy that normally drives investment and growth is going in reverse, withdrawing spending power and driving recession.

All that said, Greek banks are in a much less fragile state than they were in only three months ago. If Europe continues to hold its nose at the dubious central banking practices that are keeping Greek banks afloat, they will continue muddling along while paying out on their gradually shrinking deposits.

Three key things have happened in recent months that give Greece more muddling time:

1) Greek banks have been shielded from further losses on Greek government debt.

Until recently, the greatest danger Greece faced was that its banks would take a total loss on €50 billion of holdings of Greek government debt. That could have forced the entire Greek banking system to shut down and spurred bank runs elsewhere across the European periphery. But thanks to the second Greek bailout agreed in March, Greek banks took a much more manageable loss of roughly €20 billion, by my estimate.

At the same time, €35 billion from the bailout was set aside to guarantee Greek government debt posted to the ECB as collateral. That means Greek banks are immunized from losses on their remaining €24 billion portfolio of government bonds and notes so long as they're posted as collateral to the ECB. If the Greek government defaults, Greek banks won't have to repay cash borrowed from the ECB against Greek government debt.

2) Europe agreed to fund a €48 billion recapitalization.

Although the Greek government has been spooking markets by delaying the process, Greek banks are due to receive €48 billion of capital from Greece's second bailout, which will help prop them up even as the economy and their assets continue to weaken. That's €28 billion of additional capital on top of replacing the €20 billion loss.

This is by no means a serious recapitalization. It's more of a stop-gap liquidity plug. But it is money.

The Greek government has already received €25 billion of the recap funds, so even in if its relations with Europe fall apart before the rest of the funds are released, the €20 billion loss is more than covered.

3) Greece has proved it can liberally dispense cash to Greek banks even when the ECB refuses.

This is really critical. Under a eurozone program called Emergency Liquidity Assistance (ELA), the Greek central bank can independently create euros and lend them to its banks, apparently against even the most dubious collateral.

Since the rules that govern ELA are secret, I and other followers of the European crisis have been learning how ELA works as the crisis develops. It was known that ELA collateral standards were lower than for ECB lending, but nobody knew how low.

We learned during the restructuring, when credit agencies declared Greece in default and the ECB responded by calling in about €50 billion of its loans to Greek banks that were guaranteed by Greek government debt. The Greek central bank promptly covered the gap by lending the banks €50 billion of ELA, against the very same in-default Greek government debt that the ECB had stopped accepting.

This seeming lack of any firm minimum standards for ELA collateral appears to give Greece plenty of leeway to keep its banks afloat. If a depositor doesn't trust his Greek bank's dicey investments, no worries: the Greek central bank can accept the dicey stuff as collateral, lend newly created euros to the bank to pay the depositor, and send him and his money happily on their way.

Greece ELA spiked to about €107 billion in late February, during the restructuring. It was around €47 billion at the end of March, alongside standard ECB funding to Greek banks of about €80 billion.

ELA is currently spiking again as Greek banks rely on it to cover their losses on the restructuring until they receive the recap money. Of course, papering over a capital loss with an injection of short-term liquidity is hardly sound central banking, but Greece seems to be comfortable enough with the tactic to not be in any hurry to complete the recap. According to Kathemerini, the government is considering temporarily diverting recap money to cover its revenue shortfall and the expected delay of its next tranche of international aid.

In theory, ELA could cover even a massive bank run. Greek banks had about €190 billion of deposits and €40 billion of foreign interbank loans left at the end of March. They had more than €240 billion of loans to non-financial businesses and households, which could stretch a long way as ELA collateral if the Greek central bank applies light haircuts. If those run out, Greek banks could create ELA collateral out of whole cloth by issuing bonds to themselves.

The Distant End-Game

All folly must end eventually. Greece's ELA folly will end with the cash gone abroad and the collateral turning out worthless.

Along the way, the rest of Europe will grow increasingly nervous. ELA loans are guaranteed by the Greek central bank, which is in turn guaranteed by the Greek government. And the Greek government already can't pay its debts without help from the rest of Europe.

As the pile of ELA loans grows, northern European governments will likely begin agitating for limits to be placed on Greek use of ELA, or to cut it off altogether. If the Greek government threatens to default on its debts to Europe, the question of cutting off Greek ELA would likely be raised at the same time.

But in the periphery and in France, there will be voices for leniency. A vote to cut Greece off from ELA would be a vote to force its banking system to shut down. That would send a very frightening message to depositors in Spanish, Italian, Irish and Portuguese banks, and could create a European-wide bank run.

It requires a vote of two-thirds of the Eurozone's national central bank governors to restrict a country's use of ELA, so Greece would need only five allies to block.

My guess is that compromises will be made, and though Greece ELA might be progressively limited, it will never be cut off entirely. Likewise, Europe is likely to suspend aid-loan disbursements from time to time, but then negotiate last-minute compromises before Greece gets to the point of defaulting on its debts.

Eventually, Europeans will realize that the losses of the Greek banking system have been foisted on them, bit by bit, ELA loan by ELA loan.

There is no way Greece can ever be forced to pay for the banking losses that it is monetizing through ELA. The money is going to private parties' accounts at mostly German banks. The bad assets are hanging slightly over the Greek central bank's balance sheet, ready to be dropped there in a big, stinking pile as soon as Greek banks are cut off from central bank financing.

One way or another, the rest of Europe will end up paying for the clean-up. The only question will be whether to pay pro-actively through another, bigger Greek bailout with repayment pushed further into the future, or to pay by cutting Greece off from ELA, forcing Greek banks to shut down, and then having to replenish ECB capital wiped out by Greece's inability to make good on its guarantees of ELA loans.

Greece will never be kicked out of the Eurozone, because to do so Europe would first need to change its treaties to allow Eurozone members to be expelled. That would only increase doubts about other financially weak countries and the euro project as a whole.

But Greece might spend some time as a sort of semi-member of the Eurozone, with no access to ECB or ELA funding and perhaps its participation in ECB decisions suspended. Greeks might even decide after a banking collapse to quit the euro, so that they could at least receive something in new drachmas to replace their lost euro deposits.

And if you think that sounds like a nightmare, wait till you hear about Spain.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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